When allocating funds in a portfolio, one of the questions investors face is whether to use active or passive funds. Let's review the purpose of active fund management, how useful it is and what key criteria investors should use to make better decisions.

Active funds. What's the point?

Simply put, active managers try to beat their benchmark. They will try to pick the best countries, sectors or stocks, and gather them up in a portfolio with the expectation that their return after fees will be above their benchmark index.

Active fund managers claim they can beat the market, i.e. they can interpret information much better than other market participants and generate superior returns. While some can deliver stellar returns, the reality is that very few active managers can achieve exactly what they claim. That was the case in 2019 and will probably be the case this year too. Yet investors often pay a hefty price for active management.

The reason for this underperformance is simple, according to the tenants of Efficient Market Hypothesis: investors compete to exploit with a profit any available information about earnings, macro and many other factors that affect the value of public companies. Stock prices adjust so quickly it is almost impossible to find mispriced stocks and exploit it for a profit.

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The problem with this theory is that it claims that those few who do indeed beat the market consistently are just riding on luck. If that's the case, does it make sense to pay an active manager and when?

When to be active

If you're looking for asset managers who can beat their benchmark in markets that are not completely efficient or are not efficient all the time, this is a prime time to employ the skill of an active manager. Technically this should be the case for any market, including in the US, despite its reputation of being one of the toughest markets to beat over the long run.

The coronavirus crisis, and other episodes of market volatility - the fourth quarter of 2018, the Euro crisis in 2010-2012, the financial crisis of 2008, to name just a few - show that there are times when being active and daring to act and be contrarian can lead to outperformance.

The best way to pick investors that can deliver such outperformance is usually to consider a number of things:

  • What are the key factors behind the manager's ability to outperform (stock picking skills)?
  • Are their fees commensurate with their ability to deliver value?
  • Does the manager have a disciplined and consistent process?
  • Are their interests aligned with their investors (i.e. are they rewarded for their lasting impact on performance and not just for taking risk)?
  • Is the fund's size adequate to deliver reasonable performance (not too big or too small)?

Most of these questions usually find answers in Morningstar fund analyst reports. Our analysts have long noted that the best performing investors are usually those who are disciplined in their process, who respect their mandate and keep fees at a reasonable level, and who are usually personally invested in their funds.

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Key questions to ask

What is the level of fees?

Morningstar research has demonstrated that fee level is indicative of future fund performance. The higher the fee, the lower the future performance of a fund one can expect.

How liquid are the assets in the fund?

In the event of market volatility, investors want to make sure that the fund manager can exit some positions if necessary (although we usually recommend staying calm and to not panic in such situation). The recent experience of H2O funds in France or Woodford Equity Income shows that a poor risk management culture at a firm can arm performance and investor return.

How often does the fund manager turn over his portfolio?

Buy and hold is typically a sensible investment strategy, and good fund managers are usually disciplined both in their buying and their selling. They also dare to be different, which means their active share can be significant. But trading too much racks up costs, which eats into your returns so watch out for a manager with very high portfolio turnover. 

What is the culture and resource of the fund firm?

As well as doing your homework on the individual manager running a fund, it pays to take a look at the company he works for. The skill, culture and resources available to a manager are important aspects to check. This is another area a Morningstar analyst report can be of tremendous help, with detail about the fund firm found under the Parent pillar.  Useful information is also available in the prospectus of the fund you’re interested in. Take time to read this material.

Finally, your own ability to accept market volatility and stick to your guns is also important. When markets are in the doldrums, is your first temptation to run out of the door and sell your funds or do you prefer to stay calm, and check if there are not opportunities to jump on? This means you have done some thinking about your financial goals and the best asset allocation that can help you reach them.

Jocelyn Jovene is the editor of Morningstar France.